Fixed or Variable Interest Rate - Which is the Best Option for You?
When you approach a financial institution to take out a home loan you will be faced with choosing between a fixed or variable interest rate. There are numerous factors to take into account and several pros and cons to weigh up.
Both types of interest rates can be very beneficial but they also come with their own sets of risks. It all boils down to your current budget and whether or not you are willing to bet on the market conditions playing in your favour.
So, which one is better? Here is a short breakdown to help you make the right decision.
1) How do home loan interest rates work?
Any financial institution that gives you a loan expects it to be paid back with interest. When your interest rate is calculated, the instruction bases it on how big of a risk you might be.
You naturally want the interest rate to be as low as possible. You can achieve this by improving your credit score, paying off your debts, and putting down a big deposit.
Doing the opposite will, of course, raise your interest rate. As previously stated, financial institutions offer you the option of choosing between a fixed or variable interest rate.
2) How is the interest rate determined?
Whilst it is important to have an excellent credit score and a big deposit, there is one more factor that influences your interest rate: market forces. If the market interest rate increases or decreases, so will your interest rate.
The South African Reserve Bank determines the interest rate and this is the rate at which they lend to South African banks. This interest rate determines the prime interest rate offered to you by banks. The prime interest rate is higher than the interest rate determined by the South African Reserve Bank (also known as the repo rate). This is done so that banks can also make a profit.
When the reserve bank lowers its interest rate, so do banks which means that more people will qualify for a home loan.
3) Which is best - a fixed or variable interest rate?
The answer to this question has to do with your budget and the risk you want to take. If you take out a home loan with a fixed interest rate you have a set amount that you will pay the bank every month. This is the best solution for people who like to budget and know exactly what they will pay in mortgage instalments every month.
A variable interest rate, on the other hand, is totally dependent on the market conditions. As the interest rate fluctuates, so will your mortgage payments. This is a good option for people who choose to gamble and see whether they can save money further down the line.
4) Fixed or variable interest rate - what are the pros and cons?
Fixed interest rate
- 👍 Pro - You can create a budget that is accurate every month because your interest rate will stay the same. Your interest rate is totally unaffected by the market conditions.
- 👎 Con - A fixed interest rate is more of a risk to the bank so they will charge you a higher interest rate from the start. Fixed interest rates also expire after some time after which you will have to revert to a variable interest rate or renegotiate with the bank.
Variable interest rate
- 👍 Pro - If the interest rate drops, so will your mortgage payments. You pay less each month and you can save money.
- 👎 Con - However, if the interest rate increases, so will your mortgage payments. This type of interest rate makes it difficult to budget.
Final thoughts
As previously stated, the interest rate that the bank offers you is not only dependent on market forces. Banks look at your credit history and credit score as well as the deposit you are willing to put down. Different banks will put different offers on the table. The best thing that you can do is to shop around and compare before making the final decision.